Since its enactment in 1981, the
credit for increasing research activities (R&D
credit) contained in Sec. 41 has provided an
incentive for U.S. companies to conduct domestic
research to develop and introduce new and improved
products. The R&D credit has served as a
business stimulus by retaining and creating U.S.
jobs, generating intellectual property, introducing
new products in the United States, and increasing
the efficiency and competitiveness of U.S. companies
in the world marketplace. (When this item was
written, the Sec. 41 R&D credit had expired at
the end of 2011, and no action had been taken to
extend it; however, Congress has often retroactively
reinstated the credit.)

Sec. 41(a)(1)
provides an incremental tax credit for increasing
research activities equal to 20% of a taxpayer’s
qualified research expenses (QREs) for a given tax
year above a base amount, which generally requires a
taxpayer to have gross receipts in one of its tax
years before the credit can be claimed. Because of
the complexity of the rules for calculating the
credit, Congress added the alternative simplified
credit (ASC) as part of the Tax Relief and Health
Care Act of 2006, P.L. 109-432. Under Sec. 41(c)(5),
a taxpayer may elect to take an ASC equal to 14% of
the excess of QREs for the tax year over 50% of the
average QREs for the three preceding tax years. If a
taxpayer has no QREs in any one of the three
preceding tax years, the ASC equals 6% of the QREs
for the tax year for which the credit is being
determined.

Prior to the ASC, it was generally
assumed that start-up companies that had yet to sell
any of the products they were developing could not
claim the R&D credit because they did not have
any gross receipts and therefore could not compute
an appropriate base amount as required under Secs.
41(c)(1) and 41(c)(3)(B). The ASC provides a welcome
mechanism for claiming the credit under these
circumstances. However, the ASC must be claimed on
an originally filed return, meaning that, if a
credit was not claimed on a prior open tax year
return, a taxpayer cannot amend those returns to
claim the credit.

The market-based economy in
the United States has been built by people who set
out to put their ideas into practice and develop
products well before a market existed for those
products. These types of entrepreneurial activities
carry tremendous risks. An example today would be a
technology or software company seeking to develop
the next best software platform or an experimental
drug maker developing a new drug. The ability to
amend returns and claim the R&D credit in open
years would provide a nice payback for these types
of risk takers. While the company likely would not
recognize an immediate benefit from the credit since
it does not have any sales or profits, the credits
generated may be carried forward 20 years.

A
taxpayer’s gross receipts only matter in determining
the appropriate base amount under Sec. 41(c). Once
the base amount is calculated, gross receipts no
longer factor into the credit calculation.
Additionally, a company in its first year of
operations that has QREs does not need to have gross
receipts to calculate the R&D credit. The credit
equals 20% of the excess (if any) of the QREs for
the tax year over the base amount under Sec. 41(a).
The base amount is the product of the fixed-base
percentage and the average annual gross receipts of
the taxpayer for the four tax years preceding the
tax year for which the credit is being determined.
However, the base amount can never be less than 50%
of the QREs for the credit year.

The
fixed-base percentage is computed as the aggregate
QREs for tax years beginning after December 31,
1983, and before January 1, 1989 (i.e., the base
period), divided by the aggregate gross receipts for
the same period.

Start-up
Companies

As defined under Sec. 41(c)(3)(B), a start-up
company is any company whose first tax year with
both gross receipts and QREs begins after December
31, 1983, or any company that has fewer than three
tax years between December 31, 1983, and January
1, 1989, with both gross receipts and QREs. For
the first five tax years beginning after December
31, 1993, for which the start-up company has QREs,
the fixed-base percentage equals 3%.

The fixed-base percentage in subsequent years is
based on a moving average formula, starting in year
6, where it is one-sixth of the aggregate QREs
divided by aggregate gross receipts for years 4 and
5. The fraction and the number of preceding base
years increase incrementally until the fixed-base
percentage in year 11 and thereafter is 100% of the
QREs divided by gross receipts for any five years
among the fifth through 10th years.

Lack of Gross Receipts

There
has been much ambiguity as to whether the start-up
company rules preclude a taxpayer from calculating
or claiming the R&D credit when the taxpayer
lacks gross receipts for its first year of
operations or any open return year. Though nothing
in the IRC specifically requires a start-up company
to have gross receipts to claim the R&D credit
or be considered a start-up company, the rules in
Sec. 41(c)(3)(B) appear to imply that a company must
have both gross receipts and QREs to qualify as a
start-up company.

Regs. Sec. 1.41-3(a)
provides additional conventions for new taxpayers.
In the case of a taxpayer that has not been in
existence for the prior four years, the average
annual gross receipts are calculated based on the
number of tax years the taxpayer has been in
existence prior to the credit year. This also
supports the position that lack of gross receipts
does not preclude taxpayers from claiming the
R&D credit because there is no mention that a
tax year with zero gross receipts should be
excluded. On the contrary, it adjusts the
calculation simply based on the “existence” of the
taxpayer.

The wording in Sec. 41(a) for the
basic calculation does not explicitly mention gross
receipts. Instead, only QREs and the base amount are
part of the overall calculation. Because QREs by
definition do not include the taxpayer’s gross
receipts, gross receipts or a lack of gross receipts
in a particular tax year can only affect the base
amount. The base amount is the product of the
fixed-base percentage and the average annual gross
receipts of the taxpayer for the preceding four tax
years. The fixed-base percentage for the first five
tax years is 3%. The base amount calculation through
the fifth year of operations expressed as a
mathematical formula is: Base amount = 3% × (average
annual gross receipts of the preceding four tax
years that the taxpayer was in existence).

If
the start-up company has no gross receipts in its
first year of operations, then a taxpayer can still
calculate its base amount with the above formula. In
addition, the taxpayer may still be required to
determine its base amount using other limitations.
In very strong language, Sec. 41(c)(2) states that
“[i]n no event
[emphasis added] shall the base amount be less than
50 percent” of the QREs for the tax year in which
the credit is sought. In other words, a taxpayer’s
base amount can be more than 50% of its QREs, but if
the calculated base amount is anything less than
50%, the base amount is limited to 50% of the QREs.
As a result, a start-up company without any gross
receipts in year 1 but with QREs, will calculate the
R&D credit using the formula below: R&D
Credit = 20% × (QREs – 50% of the QREs)
or QREs × 10%.

Theoretically, a company qualifying as a
“start-up company” could calculate the R&D
credit without ever having gross receipts by
applying the 50% QRE rule to determine the base
amount. However, a real-world company would
ultimately run out of money to continue funding
its QREs after several years with no gross
receipts.

Conclusion

For years, some practitioners have incorrectly
assumed that the lack of gross receipts precludes
taxpayers from taking the R&D credit. It is
vital that practitioners be aware of this
erroneous assumption and its potential
implications on current and future tax positions.
Specifically, practitioners should take a close
look at situations in which they may have forgone
the R&D credit because the taxpayer had no
gross receipts to ensure that the taxpayer has
obtained the maximum allowable credits available
to it under Sec. 41.

EditorNotes

Mindy Tyson Cozewith is a director, Washington
National Tax in Atlanta, and Sean Fox is a director,
Washington National Tax in Washington, DC, for
McGladrey & Pullen LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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